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Key Takeaways
– After another strong month in August, market volatility returned in the beginning of September

– Tech led the rally and has led to the downside in the pullback

– Even with the pullback, valuations remain stretched

 – Economic data is still headed in the right direction

 

Pullback To Start The Month For No Obvious Reason
Source: Factset

After setting record highs to start the month, stocks quickly reversed course with some market volatility. At the time of writing, stock had fallen dramatically for three straight days. However, they bounced a bit on 9/9/20, only to fall again on the next day. There are no clear reasons for the selloff. Conversely, there was not much to support the large run up that we saw in August. Technology stocks led on the downside and also had led on the upside. To us this points to profit taking heading into the election. As tech earnings were the strongest of all sectors in Q2.

 

Technology Industry
Technology has demonstrated the most resilience to the pandemic induced recession. We would have expected tech to outperform other sectors. If this market movement truly was a fundamental repricing of the prospect of economic recovery. At this point, we think it just boils down to stocks had come a bit too far, too fast. This is evident based on valuations. As the chart shows, the ratio price of the S&P and the expected earnings, called the forward PE ratio, has not been this high since the Tech bubble of the late 90s and early 2000s.

This means it is hard to say if the selloff will stop. Because to get back to historic valuations the market would need to fall roughly between 30-50%. Assuming earnings estimates do not move higher, which they are likely to do. We do not expect that severe of a drop. However, it is disconcerting to have so much room to fall before making stock appealing from a valuation perspective.

 

Economic Data Still Improving
Source: Factset

The good news is that the selloff is not due to deterioration in economic data. Unemployment fell in August and over a million jobs were added in the economy; this number was lower than the expected 1.3 million, but is still very good. The trend is definitely positive, but the economy is still in a very deep hole. Payrolls peaked at about 152 million before the shutdown and despite a few strong reports, are still 12 million jobs short of pre-COVID levels.

It will be a long time before the labor market normalizes. There are signs of a slowing pace of recovery, especially in initial jobless claims, but overall data continues to come in ahead of expectations. The Citi Economic Surprise Index, measures how actual data compares to expectations and has been in record territory since mid-July of this year. In the context of the pullback in equities, this does offer support, but stocks did rally way ahead of economic fundamentals.

 

Where do we go from here?
At this point, the markets look to be in a healthy correction. The pace of equity gains was just too much to maintain, and this pullback is serving to get things back in sync. In our opinion, this will stay as a healthy correction with somewhere between 10-20% downside, as long as economic data holds up. Additionally, this may be the impetus to get Congress to act on a much-needed stimulus bill, which could be what brings an end to the selloff. Outside of that, there really isn’t much reason to take on risk heading into the election. We think it could easily be a couple months of choppy action, which would ultimately be healthy.

 

What should I do?  
It is important to view this pullback through a longer-term lens. There had to be some reconciliation between stock prices, earnings and economic fundamentals. We certainly would have preferred sideways action in stocks to allow fundamentals to catch up, but that was not the case. For such a deep recession, stocks have done incredibly well. We have moved our asset allocation models to a more neutral stance and are perfectly happy to wait out the election or for some resolution on the stimulus bill. We do not expect a repeat of February, though would not be shocked if the market fell further. Market volatility.

To learn more about the writer of this article, Cormac Murphy, CFA, visit: https://adamswealth.stealthmedia.com/team/cormac-murphy/

Or connect with him on LinkedIn: https://www.linkedin.com/in/cormac-murphy-cfa-33897914/.

Disclosure:

Adams Wealth Management is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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